This paper is non-committal but essentially skeptical. The authors make a few points:
1. Hedge fund customers are wealthy and sophisticated; there is no customer protection motive for regulating hedge funds.
2. Hedge funds serve some useful purposes, including private research, price discovery, and provision of liquidity.
3. Secrecy is the essence of hedge fund activity. For that reason, the standard regulatory recipe of disclosure has limited applicability in this context.
4. There is not much evidence that hedge funds are destabilizing at the macro level, or involve significant levels of systematic financial risk.
I believe these views are likely correct. The more important question is what is the best course of action — in terms of expected value – if they might be wrong. Systematic risk is the real issue.
Note that hedge funds are now appearing in activities far from the securities markets. Hedge funds have loaned money to insurance companies [sic], and bought immense amounts of real property for development. The demand for unregulated investment vehicles, and the corresponding power to raise capital, seems powerful enough to make them a dominant source of investment for almost any purpose.
This paper was written last year. In the first part of this
year the size of hedge funds in certain categories rose by
50%. At a minimum this is unusual and probably drove NY Fed
Geithner to his worried remarks at Jackson Hole. The policy
approach that the authors take amounts to having the New York
Fed president handle it privately with those involved as was
done with LCTM. Geithner has openly worried about the systemic
risk problem, to which there is clearly no easy solution.
I also note that the paper recognized that the funds could
contribute to herding and bubbles, but in the end said the
evidence on whether they have done so or not is mixed.
Is the first claim about hedge fund clients still true?
A little regulation is similar to being a little pregnant. Hedge funds are doing things that use to be done with other instruments till they were regulated. Regulate Hedge funds and something else will spring up under a different name. Say Risk Analysis Mutual Bond Organizations (RAMBO for short).
My suggestion to fix the problems is more auditors to find the doggy schemes and shut them down quietly. Hedge funds use regulated entities which can be used to form a picture of what is going on.
All it will take are a couple more spectactular failures like Amaranth. It is rather hard to say where the 4-5 billion dollars disappeared to when they collapsed – did it vanish in bad bets, or did some of the participants pocket it while claiming it vanished in bad bets? Will the incompetent/guilty parties manage to hide their participation in the next hedge fund they set up?
Amaranth’s prospectus flat out said that no investment subject to ERISA reporting were permitted in their fund. That meant they knew they were doing something that wouldn’t/couldn’t stand the light of day.
>4. There is not much evidence that hedge funds are destabilizing at the macro level, or involve significant levels of systematic financial risk.
LTCM almost took down the financial system. “Not much evidence” means you’re practising selective amnesia. The secrecy of hedge funds, lack of regulation, oversight, and opacity of the system guarantee that you can neither prevent nor remediate the risk of another LTCM from happening until it is too late, and they endanger the rest of us.
I have worked at a major hedge fund and at regulated financial institutions. Some comments:
– The effect of any regulations is likely to be to move more hedge funds offshore, and to replace American capital with foreign capital. Do we really want to decrease the spread between what the US earns on foreign assets and what foreign capital earns on US assets?
4. Stability — note that LTCM DID NOT destabilize the system. The LTCM crisis is an example of existing regulations working, not of the need for more regulations.
3. Secrecy — mickslam says secrecy is overrated and that “only a few” funds actually need secrecy to protect their investment styles. Should we abandon medical research because “only a few” new drugs are really new innovations, and many more are copycats?
Misklam.
Regulation is paid by taxpayers.Why make average Joe to pay for the risk the rich want to take?
I’m going to outline my amateur concern:
1. Hedge Funds are only available to weathy and sophisticated investors.
2. Wealthy and sophisticated investors are of a more homogenous mindset regarding economics and finance than the entire population at large.
3. Therefore any significant errors of judgement resulting from that particular economic and financial mindset have less counterbalancing forces at work in the market. For instance, if the consensus of enthusiasm about China turns out to be misplaced, there are less likely to be Hedge Funds that would profit from a Chinese slowdown or crash than there otherwise would be.
4. There is more systemic risk with restricted investment than if Hedge Funds were made available to the general public.
The hedge fund structure is the most efficient form for managing investments in today’s market, from the viewpoint of the manager. Particularly in regard to trading books and illiquid / unrated positions. Many hedge fund strategies are/were the province of commercial and investment banks. It is often more regulatorily efficient for a bank to conduct business with a hedge fund as counterparty than to keep the business on book, and the freedom and compensation’s notably better for the managers. Fund investors put up with the illiquidity and opacity, but aren’t too much worse off than owning these businesses through, say, Goldman Sachs stock.
Remember that the definition of hedge fund is a negative one — it is an entity that fits below the level deemed necessary for regulation, as it has too few investors and no unsophisticated ones.
The secrecy point is a canard, as others have pointed out. Sarbanes-Oxley hasn’t killed off bank prop desks.
OK, back to running the fund…
My sense is that #4 is really the only one that matters.
If you’re going to play in the public capital markets, then play by the same rules that govern the other players. HF have long since stopped being passive investment vehicles by which institutions and the rich had top-notch talent managing their money. HF and their close cousins, private equity investors, are today the big swinging dicks on Wall Street. Exactly how big can’t be answered because their activities lack transparency.
All the arguments that HF are fundamentally benign in terms of their net effect on the financial system as a whole are true — until something happens and they stop being true. That’s when we see that HF do indeed affect all the other players and not in a good way.
Misklam.
Regulation is paid by taxpayers.Why make average Joe to pay for the risk the rich want to take?
Because I think they should be available for retail and small investors.
DK,
What was done in 1998 was extra-legal, not illegal,
but also outside the standard regulatory structure.
They played it by ear entirely, and from what I have
heard it was a much more dangerous situation than has
ever been publicly acknowledged.
I never said a word about the SEC. I am not sure what
should be done about this, but I share Geithner’s concern
that we are in an unprecedented and increasingly dangerous
situation. There is literature that suggests that one
may gain local and short-term stability at the cost of
global instability, aka systemic fragility. The enormous
surge of these funds just in the last year, along with
the proliferation of every higher orders of derivatives
that are interlocked with each other in ways that simply
nobody knows or understands is reason to be worried,
although given that little can be done, not to get
worried that one loses sleep over.
It’s important to note that point #1 (“Hedge fund customers are wealthy and sophisticated; there is no customer protection motive for regulating hedge funds.”) is terribly oversimplified. Hedge fund customers include pension funds, whose plan sponsors and managers reap most of the benefit of outsize gains, and whose beneficiaries bear the risk of losses. Hedge fund investors include many other institutional investors (university endowments, etc.) whose ultimate stakeholders cannot be described as wealthy and sophisticated. (More here Agency Costs and Leveraged Investment Funds).
I think that systemic risk related to hedge funds is very real. Even so, I don’t think a traditional, intrusive regulatory regime would be the right approach. I broadly agree with the comments of a guest above “Get rid of the limited liability put. That’s the only regulation you need.” (More shameless self-linkage: I’ve described the “limited liability put” in slightly different terms here. For a very simple way of “getting rid” of this distortion, try here.)
Steve Waldman,
Well, no limited liability put is narrower than your no
limited liablity period. I doubt you will get yours passed,
but it might work. The no limited liablity put however seems
a bit one-sided, ruling out the possibility of a whole range
of derivatives that straddle and spider and combine longing
and putting. That would certainly cut the action way back,
and if imposed in an ex post facto way, would tank the whole
system.
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I’d say that with the stock market crash, the practice that really needs to end is the “teaser rates” of these home loans.
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